IL Dept. of Revenue: Privilege Tax Is Unconstitutional and Won't Increase Revenues

UpIL Dept. of Revenue: Privilege Tax Is Unconstitutional and Won't Increase Revenues

 

Revenue’s Legislative Position Paper

SB 1719 SFA002 Sen. Biss, Daniel (D)

Position: 

Prepared by Hooper Jones on 5/25/2017
Status: Arrived in House
Committee: Revenue and Finance
Effective Date: Immediately
Initiated By: Rep. Emanuel Chris Welch
 
SUMMARY OF CHANGES THE BILL PROPOSES TO MAKE:
Synopsis As Introduced
Amends the Illinois Income Tax. Imposes a privilege tax at a rate of 20% on partnerships and S corporations engaged in the business of conducting investment management services, until such time as a federal law with an identical effect has been enacted. Provides for the determination of the tax due, defines "investment management services". Effective immediately, but this Act does not take effect at all unless the states of Connecticut, New Jersey, and New York enact laws having an effect identical to this Act.
 
Senate Floor Amendment No. 2
Replaces everything after the enacting clause. Reinserts the provisions of the introduced bill with the following changes. Provides that the privilege tax shall be imposed beginning on July 1, 2017. Provides that the tax shall be imposed at the rate of 20% of the fees calculated by reference to the performance of the investment portfolio funds and not from the investment itself (in the introduced bill, at the rate of 20% until such time as the United States Congress has passed and the President of the United States has signed legislation having an identical effect). Provides that the tax shall not be imposed on fees calculated by reference to the total assets under management of the business engaged in investment management services. Removes the bill's immediate effective date and the bill's effective date contingent upon the states of Connecticut, New Jersey, and New York enacting laws having an effect identical to the bill.
 
FISCAL IMPACT:
According to Department of Revenue legal staff, since the privilege tax applies to the investment manager’s income, this bill violates Article IX, Section 3(a), which states, “At any one time there may be no more than one such tax imposed by the State for State purposes on individuals and one such tax so imposed on corporations.” Where the fees are business income, and that business is conducted multistate, the tax will also violate the federal constitution because it does not provide for apportionment.
If, however, the surcharge were determined to be constitutional, the Department of Revenue estimates that in the long-run, this bill would raise no new revenue for the state. Due to the magnitude of the tax, this bill would elicit a strong behavioral response from would-be taxpayers. Taxpayers would be strongly incentivized to relocate the taxable activity so that it is beyond the reach of the state. In the unlikely event that this were to be implemented before taxpayers could respond, or if taxpayers failed to respond as we would expect, the surcharge could raise as much as $206 million for a full 12 months of implementation. Although the privilege tax takes effect July 1, 2017, it is unclear how or when the surcharge would be collected. As a result, we are unable to determine the revenue impact in any given fiscal year.
To arrive at our estimate, we began with the size of the hedge fund industry in Illinois. According to a report published by Preqin in 2016, the size of the Illinois hedge fund industry, excluding funds of hedge funds, was $107 billion.[1]
We then needed to estimate the total annual return to be expected on $107 billion in hedge fund assets so that we could calculate the amount of fees earned by asset managers based on portfolio performance. Over the past 20 years, according to Barclay Hedge, Ltd., overall hedge fund performance has ranged from an annualized low of negative 21.63 percent in 2008 to an annualized high of 36.56 percent in 1999.[2] This range demonstrates that determining the annualized return for any future year is exceedingly difficult. As a result, we looked at the average annualized return over the past seven years, from 2010 through 2016. We calculated this to be 4.83%.
When applied to the $107 billion in assets, the total annual return for Illinois-based hedge funds is $5.17 billion. Assuming that hedge funds apply the “two and twenty” fee structure,[3] performance fees earned by asset managers would be $1.03 billion. By applying a surcharge rate of 20 percent to this amount, we arrive at a revenue estimate of $206 million.
There are several significant risks to this estimate that deserve attention. First, as noted above, we would expect such a high tax rate to elicit a strong behavioral response by asset managers to shield income from taxation. Other states with similar legislative proposals have recognized this risk and addressed it by inserting language into the bill so that the tax would only take effect if several other states with substantial hedge fund industries were to pass similar legislation.[4]
Second, the volatility in the performance of hedge fund portfolios would result in this being a highly volatile revenue source. Consequently, forecasts for this revenue source would be unreliable.
Finally, as addressed by Department of Revenue legal staff, constitutional issues may prevent the state from collecting any new revenue from the surcharge.
OUTSTANDING QUESTIONS:


[1] Preqin, Ltd. (2016). Preqin Special Report: Hedge Funds in the US. Retrieved from https://www.preqin.com/popupdownload.aspx?url=https://www.preqin.com/docs/reports/Preqin-Special-Report-Hedge-Funds-in-the-US-October-2016.pdf.
[2] Barclay Hedge, Ltd. (2017). Barclay Hedge Fund Index. Retrieved from https://www.barclayhedge.com/research/indices/ghs/Hedge_Fund_Index.html.
[3] According to Investopedia, “two and twenty is a type of compensation structure that hedge fund managers typically employ in which part of compensation is performance-based. This phrase refers to how hedge fund managers charge a flat 2% of total asset value as a management fee and an additional 20% of any profits earned” (http://www.investopedia.com/terms/t/two_and_twenty.asp).
[4] See Connecticut House Bill 6973 for Session Year 2017.